Adjusting to peak oil...  Future shock!

<a href=www.vheadline.com>Venezuela's Electronic News Posted: Friday, June 06, 2003 By: Andrew McKillop

VHeadline.com petroleum industry commentarist Andrew McKillop writes: Like it or not, the world is moving rapidly to absolute peaks in the capacity to find, prove and extract ever more oil and gas. The time to reach Peak Oil, the maximum possible production rate for ‘all liquids’, that is including heavy oil and tarsand or bitumen-based oil as well as conventional crude, is probably less than 7 years depending on how world and regional demand profiles evolve.

This can be understood by just a few figures. The ASPO organization, using widely available data forecasts that world peak oil production will be around 83 Mbd (million barrels per day). The USA with about 285 million population consumes about 20 Mbd. When or if China, with its current 1.25 billion population, achieved today’s rates of per capita oil consumption in the USA it would need slightly more than 80 Mbd. When or if India, with its current 1.1 billion population and, like China experiencing explosive industrial investment and output growth, achieved the same levels of oil consumption and the economic wellbeing (in classic terms) that goes with an energy intense economy, then India would need about 70 Mbd.

Together, China and India would require about 150 Mbd, if we assumed they experienced zero population growth, but continued the current and rapid expansion of their automobile, aerospace, military, consumer manufacturing and urban development sectors, and made no ‘energy transition’ away from oil.

Even if the USA made that transition, and achieved a complete replacement of its current oil utilization by non oil, or domestic-only oil and other sources, the net increase of world oil demand due to China and India attaining 2003 levels of US per capital oil demand would be some 130 Mbd. In theory ... and it is pure theory ... this could take place in not much more than 30 years, for example if China and India made the same progress to industrialization and urbanization achieved by South Korea through 1965-2000.

In fact, not only will China and India increase their oil intensity per capita, from levels that today are far less than one-tenth those of the USA ... but for some while they will also experience continuing population growth, just like the USA.

If we assume that conventional urban-industrial development in a globalized, growth economy is inevitable and unstoppable then future oil demand could in theory attain the fantastic levels suggested above ... but supply certainly will not.

For these reasons, and in an attempt to ‘square the circle,’ agencies such as the OECD’s International Energy Agency calmly publish forecasts that the world will be producing about 120 Mbd in the 2020-25 period. According to ASPO, and a growing number of oil geologists, consultants, advisory groups and ... without openly stating this ... increasing numbers of oil industry majors, this is simply impossible. By about 2010 production, and therefore demand, can only fall if slowly at first.

Economic shock

Whether our doctrinal stance is New Economics, or simple supply-and-demand the impact of flagging supply and increasing demand usually means rising prices. The word ‘usually’ is important because a simple refusal to accept reality can be adjusted for, by the economy and society, through setting unreal prices. In the quite recent past this was specially the case for oil prices ... which exploded in the 1973-81 period, then shrank back to unreal, desultory price levels. This inevitably had a ‘knock on’ effect on prices for natural gas, coal, other minerals, and energy intensive commodities in general.

The merest check on how these violent oil price swings, which were only due to political factors and did not concern resource availability, affected and related to demand and consumption is revealing. Whether at the 3rd Quarter 1979 oil price of the most expensive crudes, at about $103/barrel in 2003 dollars, or the 4th Quarter 1998 oil price in 2003 dollars of about $10.50/barrel for the same crudes, world oil demand and consumption have varied little.

Oil consumption growth rates have only turned into stagnation and then fall in the sharpest, deepest recessions, notably in 1980-83, and then surged again as the world economy again expands. Oil demand growth by the fastest growing Asian industrial countries outside China (the ‘traditional’ New Industrial Countries) was in fact at its most explosive during the period of highest oil prices, during the 10-year period of 1975-85 !

Today, with much lower oil prices, these ‘traditional NICs’ now show much lower growth rates of oil demand. So-called ‘price elasticity of demand’ is far from applicable to this demand pattern, because oil prices, themselves and alone, do not set economic growth trends either nationally or regionally. However, no economic growth as we know the term is possible without oil.

Falling, even collapsing rates of economic growth in the aging, service-oriented economies of the OECD has led to economic growth becoming a leitmotiv, a desperate quest to restore growth without redistribution of wealth by any other means but the market.

Thus economic agencies of the OECD group, like the IEA are constrained to generate unrealistic, impossible forecasts for world oil demand and supply in the near future.

For their 2020-25 forecasts, the IEA and US EIA simply key in a 1.8% annual growth rate for world oil demand and then project vast supply expansion from the Middle East in particular, but also elsewhere. By 2020, according to the US EIA and the OECD’s IEA, the Middle East region could, or should be exporting about 45 Mbd, in order to balance out forecast world supply an demand needs. Including domestic oil needs of these exporters, their total production would need to exceed 53 Mbd ... despite this being almost entirely and completely impossible! Yet the future volume of oil demand that would require these heroic supply efforts is generated by the world’s appetite for oil only growing at about 1.8% per year. In the 1990s, in some years and irrespective of the oil price (sometimes when prices moved up!) oil demand growth in the Asia-Pacific region was often well above 5% per year. In its heyday of economic growth (about 1948-78), the OECD countries often experienced annual growths of oil demand of more than 6%.

Only recession can cut demand growth

Only intense economic, financial or monetary crises can in fact dent what is essentially inelastic demand generating high annual demand growth rates.

An example is the 1997 Asian monetary crisis, which for one year brought the region’s oil demand growth to slightly below zero. In the OECD or richworld economies the 1973-74 oil shock saw a 295% nominal or before-inflation price rise for oil, but demand growth rates of beyond 7% per year for some OECD nations before the crisis only turned into declining consumption for around 18 months in most of these economies.

By 1975-76 OECD country oil demand growth rates had recovered to as much as 3.5% and more each year. In the 1979-81 oil shock, when oil prices reached levels that we will surely see again within a few years, if only market mechanisms set prices, there were declines in oil demand by the OECD nations for 3 straight years (1980-83), but these only attained a total of about an 8.15% cumulative fall in demand, and were only obtained through the blunt instrument of extreme interest rates triggering wall-to-wall recession.

The imminence of entry to a 1929-36 sequence of continual, unstoppable economic decline, and the more prosaic need of the Reagan administration to have their candidate re-elected, ended this flirt with 1930s-style depression.

World oil demand ceased to fall from late 1983 and through 1984, with oil prices in 2003 dollars that were still far above $60 per barrel. In that year, the US economy attained its highest-ever economic growth, at about 7.5% expansion of real GDP (around 4-5 times economic growth rates in the G-8 nations today, with oil prices about one-half the 1984 price in real terms).

From the later 1980s, world oil demand growth increased in all regions, if at lower annual rates than before 1973 in the older industrial economies of the OECD, but at much faster rates in the dynamic Asia-Pacific economies. In the 12-year period since Gulf War-1, a war essentially for cheap oil, world oil demand has increased by nearly 13 Mbd, or about 25% more than the effective and real ultimate oil export capabilities of Saudi Arabia, the world’s biggest oil exporter. Using US EIA and OECD-IEA forecasts, world oil demand growth from 2003-10 will add about another 13 Mbd to world demand.

The kind of economic shock needed to ensure continual decline in world oil demand, solely by the price mechanism and without extreme interest rates, is hard to imagine. We could suggest that oil prices would have to exceed $125 per barrel, but the inflation triggered by this would itself lead to much higher interest rates being applied as a panic measure to save the US dollar, Euro and Japanese Yen from meltdown. Higher priced money would then intensely slow economic activity as in 1980-83, but to maintain continual, yearly declines in world oil demand no economic recovery could be permitted. The recession would have to become a depression, and that would then have to become the ‘normal economic environment’. Unemployment rates, in any formerly rich country, would have to be in the 25%-40% range and be maintained at that level. Public financing of education, health, care of the aged, transport infrastructures and the military would be severely impacted, and very likely there would be civil unrest, riot and rebellion.

Those who draw up scenarios of either sudden cuts in world demand, or continual, year-on-year falls in demand by apparently ‘modest and reasonable’ amounts of say 1.5%-per-year, must understand that the world economy, society and political decision-making system is totally unprepared for such horse medicine.

Without any prior warning nor international agreement, and either through unlimited price rises of oil, or by national legislation and rationing, this Final Oil Shock could be brought about – but the consequences would almost certainly include civil war, and quickly lead to international conflict using nuclear weapons.

Economic adjustment

Conversely, oil prices in the $40-$60 per barrel range pose no threat at all to the OECD richworld, and through increasing revenues to energy producers, and exporters of energy intense minerals and agro-commodities, notably in the ‘emerging economies,’ energy sector activity and overall or composite world economic growth rates can be maintained.

The ‘default solution’ or Final Shock of rapidly unmanageable, self reinforcing downturns in activity, employment and investment can be avoided ... prices at the above levels will however send a clear, unambiguous signal of Peak Oil’s certain arrival in an easily defined period of time, and provide some economic underpinning to the obligatory shift towards a low energy economy, mostly and firstly in the richworld OECD nations.

While the Kyoto Treaty mechanism laboriously seeks a regulatory framework for encouraging energy transition, and is ignored by the USA and inapplicable to more than 140 of the 180 countries that have ratified this process for action to limit inevitable climate change, the energy economic framework for adjustment entrained by rising oil prices will operate at all levels of the energy economy. In addition, the Kyoto process, being targeted for effective application from about 2012 (in theory from 2008-12), is unrelated to the very short term horizon that applies for Peak Oil and to which adjustment should begin with the shortest possible delay.

In other words, maintaining current low prices of oil until the 2008-10 period will provide no market signal at all of what will happen to prices after Peak Oil physically impacts world oil supply-demand balances.

After a long period of unrealistically low prices, we will experience a ‘quantum change,’ stepwise leap in oil prices as in 1973-74 or 1987-81 with all that implies in terms of panic driven, ineffective or harmful responses to what, this time, will be permanent and physical shortage of oil.

More than 5 years of potential adjustment through market driven mechanisms will have been lost if no market signals, through higher oil prices, begin to operate in the economy. Investment opportunities in energy saving, economy restructuring and new/renewable energy source development will have been squandered.

Public knowledge, and social acceptance of obligatory but necessarily challenging adaptation and modification of established ways of life will be distorted, harmed or hindered.

In a situation of ‘laisser faire’ non response to perhaps the biggest change in world energy that will ever occur, there is little difficulty forecasting a repeat of the 1980-82 sequence in the world economy. Already rising interest rates were gouged to more than 20% base rates in most OECD countries, entraining a runaway process of stock market loss, business closures and reduction of investment and employment.

Unlike the 1980-82 sequence, however, there would be no return to growth simply through cutting interest rates and allowing oil demand growth to return, firstly through physical shortage and secondly through the price factor.

In a tightening depression with a hostile interest rate environment, economic players would be very unlikely to spontaneously move toward restructuring their activity, plant and equipment, effectively aborting any rapid start of the energy transition process that the single factor of higher and sustained, but not extreme oil and energy prices would and can bring.

Energy industry and energy sector adjustment

To some extent the current ‘US natural gas cliff’ of flagging supply and stepwise increase in prices of natural gas in the USA, notably shifting considerable demand (already about 0.25 Mbd) to oil and increasing US oil imports, is a paradigm of inefficient, market-only ‘response’ to energy resource depletion.

The US gas prospecting industry, downsized through years of very low gas prices, is unable to respond. US oil import increase at this time of tightening world oil supply-demand balances will itself and certainly increase oil price volatility, and only with time leading to sustained and progressive price rises. This in turn will send confused, even contradictory price signals to the energy industry and throughout the energy economy in the short-term.

The period of around 1978-82, in which oil prices attained about $100/barrel in 2003 dollars, saw a flurry of oil and gas prospecting activity, and a short turnaround in long-term oil reserve depletion profiles, both in the US and elsewhere.

Price rises from their most recent lows (of about $9.50/barrel for some crudes in late 1998), to around $28-$30/barrel in late May 2003 have been erratic, strongly affected by political events in Iraq and Saudi Arabia, and have not led to any major upturn in prospecting, makeover activity or new production.

To some extent this is due to simple depletion, but is also due an increasingly unrealistic oil and gas pricing environment. Concerted international action to set both floor and ceiling prices for oil and gas, for set forward periods of time, would itself contribute to resolving the problem of an energy industry that is losing industrial capacity and strength every day in an increasing number of countries.

In part this is due to the political context of ‘unfettered markets’ subject to benign neglect, and the mirage of ‘vast’ oil production by the new Iraq. Under no circumstance can Iraq’s albeit large oil reserves ... but currently small production capacity ... prevent Peak Oil from happening. In the very short term of 2003-04 any export offer by the new Iraq will be small and by itself totally unable to compensate for declining supplies from other regions and provinces, given expected and likely world oil demand growth rates.

The downward pressure on world oil prices due to expected and hoped-for supply from the new Iraq, however, will only serve to draw energy investment away from oil and gas activities in other regions and provinces, while maintaining unattractive investment returns in the still fledgling new and renewable energy sector.

That is, in other words, the world energy industry is hostage to a situation of cheap oil’s last fanfare in the Middle East, losing vital industrial capacity and downsizing at exactly that moment when it should be moving towards energy transition.

Without forward development of new industrial capacity, both in fossil and non fossil fuels and energy sources, the period after Peak Oil promises to be chaotic. This again reinforces the need, first, for acceptance of Peak Oil’s reality and imminence, and the setting of international agreements for procedures to deal with it.

Conclusions

There is no difficulty, if we accept the reality of Peak Oil, in drawing up oil-only demand projections featuring annual cuts in consumption and ignoring any question of the oil price.

A sudden stepwise increase in oil prices to even the $80-$90/barrel range will, perhaps ironically, but almost certainly in fact increase economic growth at the world level, leading to yet higher world oil demand, which will then reinforce price rises. This however will entrain an economic and then political context where firstly economic recession and then deep and unyielding economic depression will inevitably set in, in the formerly rich nations of the OECD.

Much better, there should be ‘pre-transitional’ oil price rises to the $40-$60/barrel range, enabling more time for market driven adjustment to start, and to develop. This should be the subject of international agreement much like, but apart from the Kyoto process.

While this of course is somewhat idealistic, it can prevent runaway oil and energy price rises, economic depression, and military responses to what is essentially a geological problem from becoming the default solutions.

The international energy industry will itself be a key player in energy economic restructuring. At present it is a victim of erratic, even incoherent policy and market contexts and lacks critical visibility at this moment in time.

Providing a lead role to the energy industry, firstly through market signals, will be vital to any plan and program for energy transition.

Recent trends show that economic and industrial downsizing ... loss of capabilities ... is accelerating in the industry and must be turned around.

Without this partner in the transition period that will likely start within 6 years if no action is taken and world oil demand growth is set by unfettered market play, there is scant chance of serious and effective responses being set.

Andrew McKillop  is a former expert, policy and programming, Divn A - Policy, DG XVII-Energy, European Commission, founder member, Asian Chapter, Intl Assocn of Energy Economists. You may contact Mr. McKillop by email at andrewmckillop@onetel.net.uk